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Banks Don't Need to Gamble With Taxpayer Money

My experience at Merrill Lynch shows how to serve customers without engaging in proprietary trading.

By

Roger M. Vasey

April 16, 2012 7:18 p.m. ET

The Volcker Rule—part of the Dodd-Frank financial reform law—is necessary to correct a mistake that poses a danger to our economy.

The mistake was the repeal of the Glass-Steagall Act in 1999. Commercial banks have since been able to trade a wide variety of inherently risky securities with huge amounts of government-insured deposits. If the investments failed, taxpayers would have to swallow the losses. Glass-Steagall, enacted in the depths of the Great Depression, had insured bank deposits but prohibited banks from using these deposits for securities trading, and for good reason.

The Volcker Rule is intended to correct this mistake by constraining banks with explicit or even implied taxpayer support from proprietary trading. Those opposed to the Volcker Rule have a long list of objections. Prohibiting banks from proprietary trading will create illiquidity in bond markets. It will hinder banks' ability to serve clients and foreign banks. It will impose costs on banks and slow the economy.

Yet banks can achieve successful operating results without proprietary trading. The experience of Merrill Lynch in the global bond markets several years ago is a case in point.

Merrill was the largest underwriter and marketer of bonds in the world in the late 1980s and well into the '90s. It facilitated more trades for clients, including foreign institutions, than any other firm. It was the "go to" firm in the bond business at that time.

Merrill took minimal risk. Its holdings in a variety of securities (including derivatives) drifted somewhat higher at times in satisfying customer needs, but always within predetermined limits that the company set relating to the "potential for loss." It routinely carried sufficient inventories of bonds to satisfy clients' needs, but not a dollar more. Further, the company managed its inventory very closely to identify and manage any interest-rate or market risks.

During those years the debt group, which I managed, was among Merrill's most profitable businesses. The source of its revenue was consistent customer flow. The company earned a fair spread on each trade if possible and that was it.

Merrill operated with no government-insured deposits. And it avoided taking positions that carried too much risk. The reason was simple: fear of a "debt bomb" going off, just as it later did, bringing on the financial panic.

What is the answer today to the problem of banks holding large positions for their own account? Raising capital ratios as risk increases will help. But the lag time it takes regulators to make needed adjustments makes this solution alone inadequate. A much better answer is for large banks to continuously model their projected losses stemming from each position under various declining market scenarios, and to establish and enforce loss limits.

Further, each bank should closely track its inventory turnover. At Merrill, an independent risk-management group, reporting to senior management, monitored traders' loss limits. The group modeled the risks and acted when necessary. We looked at inventory turnover regularly. For example, if long-term government bond sales averaged $100 million per day, and to accommodate our customers' needs we needed $200 million on the shelf, our inventory was turning every two days and that typically became the inventory turnover limit. If the long-term bond inventory increased and turnover slowed, that indicated our holdings might pose a proprietary risk, and we would take action to reduce our position.

Today, all banks with significant securities holdings use various methods of internal risk management. Going forward, each bank should be required to agree with its regulator on conservative loss limits and maintain its risk profile accordingly. The regulator would verify a bank's overall risk-management approach periodically and have ongoing access to changes in the bank's projected risk in real time.

The number and complexity of various financial vehicles has grown over the years, but the principle remains the same. If the potential loss from a bank's overall position across its securities holdings cannot be projected accurately under various deteriorating market conditions, and effective limits on that position established and monitored accordingly, that position should not exist.

And no financial institution with explicit or implied taxpayer support should be in the proprietary trading business.